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2 Editorial Director: Sally Yagan Editor in Chief: Donna Battista Director Editorial Services: Ashley Santora Editorial Project Manager: Karen Kirincich Editorial Assistant: Jane Avery Editorial Assistant: Lauren Zanedis VP Director of Marketing: Patrice Jones Marketing Assistant: Ian Gold Senior Managing Editor: Nancy Fenton Publisher, International Edition: Angshuman Chakraborty Acquisitions Editor, International Edition: Somnath Basu Publishing Assistant, International Edition: Shokhi Shah Print and Media Editor, International Edition: Ashwitha Jayakumar Project Editor, International Edition: Jayashree Arunachalam Senior Manufacturing Buyer: Carol Melville Creative Director: Jayne Conte Cover Designer: Jodi Notowitz Media Project Manager: Sarah Peterson Full-Service Project Management and Composition: Integra Printer/Binder: Courier/Westford Cover Printer: Courier/Westford Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world Visit us on the World Wide Web at: Pearson Education Limited 2013 The rights of Lyn M. Fraser and Aileen Ormiston are to be identified as authors of this work has been asserted by them in accordance with the Copyright, Designs and Patents Act Authorized adaptation from the United States edition, entitled Understanding Financial Statements, 10th edition, ISBN by Lyn M. Fraser and Aileen Ormiston published by Pearson Education All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6 10 Kirby Street, London EC1N 8TS. All trademarks used herein are the property of their respective owners. The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affiliation with or endorsement of this book by such owners. Microsoft and Windows are registered trademarks of the Microsoft Corporation in the U.S.A. and other countries. Screen shots and icons reprinted with permission from the Microsoft Corporation. This book is not sponsored or endorsed by or affiliated with the Microsoft Corporation. ISBN 10: ISBN 13: British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Typeset in Times Ten Roman 10/12 by Integra Printed and bound by Courier/Westford in The United States of America The publisher s policy is to use paper manufactured from sustainable forests.

3 CHAPTER 2 The Balance Sheet 91 pension fund an amount that will hopefully cover the ultimate benefits that will be paid to employees in the future. The amount paid into the fund plus the earnings on the fund s assets may be less than the estimated pension obligation. In this case, a net pension liability would be included in the liability section of the balance sheet. Postretirement benefits are benefits other than pensions that employers promise to pay for retired employees. These benefits might include health and life insurance costs. While the obligation for these benefits must be estimated and reported in the balance sheet, firms often do not set aside cash to fund these obligations, causing the firms to report significant postretirement benefit liabilities. Sage Inc. has a defined contribution plan rather than a defined benefit plan. Defined contribution plans require the employer to contribute a defined amount to employees pension funds. At retirement the employee receives the amount contributed plus whatever has been earned on the pension fund. Once the employer has made the contribution to the fund, no obligation exists. Commitments and Contingencies Many companies will list an account titled Commitments and Contingencies on the balance sheet even though no dollar amount will appear. This disclosure is intended to draw attention to the fact that required disclosures can be found in the notes to the financial statements. Commitments refer to contractual agreements that will have a significant financial impact on the company in the future. Sage Inc. reports commitments in Note 3 that describe the company s operating leases. If the leasing contract does not meet one of the four criteria required to record the lease as a capital lease, the lessee will record rent expense on the income statement and a corresponding reduction to cash. Operating leases are a form of off balance sheet financing. In fact, the lessee is contractually obligated to make lease payments but is not required by generally accepted accounting principles (GAAP) to record this obligation as a debt on the balance sheet. Companies could purposely negotiate a lease as an operating lease so that the long-term commitment does not have to be shown on the balance sheet; however, astute users of financial statements will know to look at the notes to the financial statements to determine any commitment the company may have with regard to operating leases. For Sage Inc., Note 3 indicates that the company will be required to make lease payments in the amount of $176,019,000 in the future. Many firms use complicated financing schemes product financing arrangements, sales of receivables with recourse, limited partnerships, joint ventures that do not have to be recorded on balance sheets. Disclosures about the extent, nature, and terms of off balance sheet financing arrangements are in the notes to the financial statements, but they may be very complex and difficult to understand, and require putting pieces together from several different sections. Contingencies refer to potential liabilities of the firm such as possible damage awards assessed in lawsuits. Generally, the firm cannot reasonably predict the outcome and/or the amount of the future liability; however, information about the contingency must be disclosed in the notes to the financial statements.

4 92 CHAPTER 2 The Balance Sheet Stockholders Equity The ownership interests in the company are represented in the final section of the balance sheet, stockholders equity or shareholders equity. Ownership equity is the residual interest in assets that remains after deducting liabilities. The owners bear the greatest risk because their claims are subordinate to creditors in the event of liquidation, but owners also benefit from the rewards of a successful enterprise. The relationship between the amount of debt and equity in a firm s capital structure and the concept of financial leverage, by which shareholder returns are magnified, is explored in Chapter 5. Cartoon Features Syndicate Common Stock Sage Inc. has only common stock shares outstanding. Common shareholders do not ordinarily receive a fixed return but do have voting privileges in proportion to ownership interest. Dividends on common stock are declared at the discretion of a company s board of directors. Further, common shareholders can benefit from stock ownership through potential price appreciation (or the reverse can occur if the share price declines). The amount listed under the common stock account is based on the par or stated value of the shares issued. The par or stated value usually bears no relationship to actual market price but rather is a floor price below which the stock cannot be sold initially. At year-end 2013, Sage Inc. had 4,363,000 shares outstanding of $0.01 par value stock, rendering a total of $43,630, which is included in the common stock account. Additional Paid-In Capital This account reflects the amount by which the original sales price of the stock shares exceeded par value. If, for example, a company sold 1,000 shares of $1 par value stock

5 CHAPTER 2 The Balance Sheet 93 for $3 per share, the common stock account would be $1,000, and additional paid-in capital would total $2,000. Sage Inc. combines the additional paid-in capital account with the common stock account for reporting purposes on the balance sheet. The total amount in these combined accounts is $5,760,000 at the end of 2013 for Sage Inc. Because $43,630 of this amount is the par value of the shares, the balance is the additional amount paid above par value for shares of Sage s common stock. On average, the firm s common stock has sold at a price of $1.32 per share ($5,760,000 divided by 4,363,000 shares). The additional paid-in capital account is not affected by the price changes resulting from stock trading subsequent to its original issue. 9 Retained Earnings The retained earnings account is the sum of every dollar a company has earned since its inception, less any payments made to shareholders in the form of cash or stock dividends. Retained earnings do not represent a pile of unused cash stashed away in corporate vaults; retained earnings are funds a company has elected to reinvest in the operations of the business rather than pay out to stockholders in dividends. Retained earnings should not be confused with cash or other financial resources currently or prospectively available to satisfy financial obligations. Rather, the retained earnings account is the measurement of all undistributed earnings. The retained earnings account is a key link between the income statement and the balance sheet. Unless there are unusual transactions affecting the retained earnings account, the following equation illustrates this link: Beginning retained earnings Net income (loss) Dividends Ending retained earnings Other Equity Accounts In addition to the stockholders equity accounts shown on the Sage Inc. balance sheet, there are other accounts that can appear in the equity section. These include preferred stock, accumulated other comprehensive income, and treasury stock. Exhibit 2.7 illustrates these additional items for Pfizer, Inc. Preferred stock usually carries a fixed annual dividend payment but no voting rights. Pfizer, Inc. issued preferred stock in connection with an acquisition. Companies must report comprehensive income or loss for the accounting period. Comprehensive income consists of two parts, net income and other comprehensive income. Other comprehensive income is reported in a separate equity account on the balance sheet generally referred to as accumulated other comprehensive income/(expense). This account includes up to four items: (1) unrealized gains or losses in the market value of investments in available-for-sale securities (2) any change in the excess of additional pension liability over unrecognized prior service cost, (3) certain gains and losses on derivative financial instruments, and (4) foreign currency translation adjustments resulting from converting financial statements from a foreign currency into U.S. dollars. (Comprehensive income and the four items noted above are discussed in Chapter 3.) 9 The paid-in capital account can be affected by treasury stock transactions, preferred stock, retirement of stock, stock dividends, and warrants and by the conversion of debt into stock.

6 94 CHAPTER 2 The Balance Sheet EXHIBIT 2.7 Pfizer, Inc. Shareholders Equity at December 31 (in Millions, except preferred stock issued) Shareholders Equity Preferred stock, without par value, at stated value; 27 shares authorized; issued: ,279; , Common stock, $.05 par value; 12,000 shares authorized; issued: ,876; , Additional paid-in capital 70,760 70,497 Employee benefit trusts (7) (333) Treasury stock, shares at cost; ; (22,712) (21,632) Retained earnings 42,716 40,426 Accumulated other comprehensive (loss)/income (3,440) 552 Total Pfizer, Inc. shareholders equity 87,813 90,014 Equity attributable to noncontrolling interests Total shareholders equity 88,265 90,446 Firms often repurchase shares of their own stock for a variety of reasons that include meeting requirements for employee stock option and retirement plans, building shareholdings for potential merger needs, increasing earnings per share by reducing the number of shares outstanding in order to build investor confidence, preventing takeover attempts by reducing the number of shareholders, and as an investment use of excess cash holdings. If the repurchased shares are not retired, they are designated as treasury stock and are shown as an offsetting account in the stockholders equity section of the balance sheet. Pfizer, Inc. held 864 million shares of treasury stock at the end of The cost of the shares is shown as a reduction of stockholders equity. 10 Employee benefit trusts, an account shown in the Pfizer, Inc. shareholders equity section, is explained as follows: The Pfizer, Inc. Employee Benefit Trust (EBT) was established in 1999 to fund our employee benefit plans through the use of its holdings of Pfizer, Inc. stock. Our consolidated balance sheet reflects the fair value of the shares owned by the EBT as a reduction of Shareholders Equity. Beginning in May, 2009, the Company began using the shares held in the EBT to help fund the Company s matching contributions in the Pfizer Savings Plan. 11 Equity attributable to noncontrolling interests represents the equity interest Pfizer has in companies whose financial statements have been consolidated with Pfizer s financial statements but are not 100% owned by Pfizer. 10 The two methods used to account for treasury stock transactions are the cost method (deducting the cost of the purchased shares from equity) and the par value method (deducting the par or stated value of the shares from equity). Most companies use the cost method. 11 Pfizer, Inc., 2010 Annual Report, p. 93.

7 CHAPTER 2 The Balance Sheet 95 Quality of Financial Reporting The Balance Sheet An extensive discussion of financial reporting quality and its impact on financial performance is provided as an Appendix to Chapter 3, but it is important to introduce here some of the qualitative issues that relate to the balance sheet. As has been documented in earlier sections of the book, the economic recession of 2008 and many of the market gyrations since then can be traced directly to the overvaluation of balance sheet assets, such as the subprime mortgages carried by financial institutions. When financial reporting does not reflect economic reality, the quality, and thus the usefulness, of that information is significantly impaired. In addition to the overvaluation of assets, other examples of balance sheet items that relate directly to the quality of financial reporting include the type of debt used to finance assets, commitments and contingencies, and the classification of leases. In general, a firm should strive for a matching of debt to the type of asset being financed; that is, short term debt should be used to finance current assets, and long-term debt (or equity) should be used to finance long-term assets. A mismatching of debt to assets could indicate that the firm may be having trouble finding financing sources. As discussed earlier in the chapter, the Commitments and Contingencies disclosure in the notes to the financial statements should be read and evaluated carefully because these disclosures can provide important information about off-balance sheet financing and other complex financing arrangements. Enron is a prime example of a company that had enormous activity, leading ultimately to its downfall, reported in these notes to its financial statement presentation. Enron s notes included extensive discussions of financial information that was relevant to the firm s current and future operations but that was not quantified on the balance sheet, such as balance sheet partnerships, a proposed merger, price risk management and financial instruments, unconsolidated subsidiaries, regulatory issues, and litigation. The twelve pages of notes to the financial statements related to the commitments and contingencies of Pfizer Inc. in 2010 may help the financial statement user understand potential liabilities that can affect the firm in the future. Besides operating lease commitments and guarantees, Pfizer is involved in many legal proceedings. Some of the lawsuits Pfizer is party to involve patents, product litigation, commercial matters, and government investigations, among other legal proceedings. Though most of the information in the notes cannot be quantified on a financial statement, the notes do allow readers to determine that there are significant litigation issues. Also included in the commitments note is information relating to capital and operating leases. While capital leases are included on the balance sheet, the financial statement user should consider the effects on debt ratios (discussed in Chapter 5) if operating leases are extensive because the firm is committed to making lease payments, similar to payments involved in servicing debt. If such leases had been negotiated as capital leases, there would be a higher amount of debt on the balance sheet. The consumer goods retailer Walmart provides a good example. Walmart reported long-term debt in the amount of $40.7 million and capital lease obligations of $3.2 million in In addition, Walmart had $14.1 million of operating lease commitments, reported in the notes to the financial statements, and the analyst would want to be aware of the increased risk associated with this off balance sheet item.